The International Swaps and Derivatives Association is planning to send a second comment letter to the Department of the Treasury and Internal Revenue Service in an attempt to soften the authorities' tax proposals on contingent swaps. ISDA declined comment.
David Miller, partner at Cadwalader, Wickersham & Taft in New York, thinks the impact of the regulations, if they go through in their current format, could be huge. He added, "On the face of it the proposed regulations appear to apply to credit derivatives." This is because there is a periodic payment on one side, the protection buyer pays the seller, but the opposite payment stream is contingent on a credit event, which would only happen once and could be at any time during the life of the contract. Miller, however, thinks it is unlikely the tax authorities meant to include credit derivatives and is expecting clarification on this issue.
The tax authorities are changing the rules to close a loophole in which contingent swaps can be used to defer paying tax, according to a lawyer. The draft comment letter, obtained by DW, states, "The Proposed Regulations evidently are focused primarily on trying to prevent perceived abuses of the current wait-and-see approach, which we believe are rare and unusual transactions that be dealt with readily under current law, or if necessary, with an enhanced anti-abuse provision." The trade association's second objection stems from the proposed regulations inconsistency with existing regulations. "[They] fail to satisfy the sound tax policy objectives set forth by the Treasury and the IRS in Notice 2001-44."
The trade association wants the IRS to allow counterparties to adopt a wait-and-see approach for swaps under five years, in which the contingent payment is not taken into account for tax purposes until the payment amount is fixed. For longer-dated transactions it accepts that all income and deductions should be deferred until the payment is made. In addition, ISDA argues that all taxpayers should be allowed to use mark-to-market valuation for their swaps along with any hedges. One lawyer said the trade association likely chose the five-year date because most transactions are under five years.
ISDA sent its first comment letter in March and it focused on the effective date and retroactive issues raised in the proposals. The comment period closed in May, but lawyers said the authorities are still likely to read ISDA's letter because the rules are not yet finalized.
